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Industrial Organization
Oligopolistic Competition
Both the monopoly and the perfectly competitive market structure has in common
is that neither has to concern itself with the strategic choices of its competition. In the
former, this is trivially true since there isn’t any competition. While the latter is so
insignificant that the single firm has no effect. In an oligopoly where there is more than
one firm, and yet because the number of firms are small, they each have to consider
what the other does. Consider the product launch decision, and pricing decision of
Apple in relation to the IPOD models. If the features of the models it has in the line
up is similar to Creative Technology’s, it would have to be concerned with the pricing
decision, and the timing of its announcement in relation to that of the other firm. We
will now begin the exposition of Oligopolistic Competition.
1 Bertrand Model
Firms can compete on several variables, and levels, for example, they can compete
based on their choices of prices, quantity, and quality. The most basic and funda-
mental competition pertains to pricing choices. The Bertrand Model is examines the
interdependence between rivals’ decisions in terms of pricing decisions.
What is the equilibrium, or best strategy of each firm? The answer is that both
firms will set the same prices, p1 = p2 = p, and that it will be equal to the marginal
ECON 312: Oligopolisitic Competition 2
cost, in other words, the perfectly competitive outcome. This is a very powerful model
in that it says that price competition is so intense that all you need is two firms to
achieve the perfect competitive outcome. We will show this through logical arguments
and contradictions, as well as through the use of a diagram.
1. Firm’s will never price above the monopoly’s price: Suppose not. And
suppose firm 1 believes that firm 2 would choose a price p2 above the monopoly’s
price, then the best response of firm 1 is to price at the monopoly’s price since
at that point, its profit is maximized. And firm 2 would be driven out of the
market. Therefore no firm would ever price above the monopoly’s price.
2. In equilibrium, all firm’s prices are the same: Suppose firm 2 chooses to
price at the monopoly’s price, what is the best response of firm 1? Firm 1 would
realize that by pricing at a slightly lower price, it would be able to capture the
entire market since the goods are perfectly substitutable, that is p1 = pM + ,
where pM is the monopoly’s price , and > 0. Then only one firm is left.
Therefore the equilibrium where firms charges a different prices cannot be an
equilibrium, p1 = p2 = p.
an equilibrium since the actions that one believes the other would do would never be
realized. Only at c does their expectations match, and the equilibrium is sound since
both firms are the same, symmetric.
p1 6 45o
pR
2 (p1 )
pM
pR
1 (p2 )
c u
Bertrand-Nash Equilibrium
-
c pM p2
price competition does not have the power to drive prices down to marginal cost.
We will consider this again when we examine product differentiation.
2. Dynamic Competition: The Bertrand Model assumes that the pricing game
is a one shot game, which is hardly what really occurs since the lifespan of a firm
is typically more than one period. Recall our multi period simultaneous game
where we found that agents could achieve mutually beneficial outcomes that
would otherwise not have been possible. Extending the idea, when we consider
the pricing competition game over a finitely large number of periods, and that
the game is repeated in each, it is possible for the firms to achieve an equilibrium
where prices are greater than marginal cost.
3. Capacity Constraints: The implicit assumption of the last model is that the
firm in deviating and undercutting it’s competitor obtains the entire marker, it
is able to meet the full demand of the market. However, this need not be true
all the time, that is the firm has an endogenous constraint in the sense that it is
not possible for it to meet all of the demand of the market should it undercut its
competition.
Maintaining all of the previous assumptions, we augment them with the additional
assumption that each firm has a capacity constraint of ki , i ∈ 1, 2, such that even if the
demand for their homogenous product is greater than they can produce, they are not
able to meet it. Further, without loss of generality, suppose k1 ≤ k2 , and for simplicity,
assume here that c = 0
Let us examine what the optimal price would be should the firms act in concert
as one, i.e. a monopoly. Given that marginal cost is zero, they would maximize their
profit when they utilize their capacity to the maximum, i.e. a corner solution, since
the marginal revenue would never be zero given positive prices. We will now adopt
similar arguments to prove our above conjecture.
(a) Suppose firm 2 chooses to price above this price, but that would mean that
the profit could always be increased by raising their output. Consequently,
they would never do this.
(b) Suppose firm 2 chooses to price below the price of P (k1 + k2 ). But since
the price set by firm 1 is at the point where both firms would be producing
at capacity. By firm 2 choosing to deviate and pricing below P (k1 + k2 ), it
actually would not be able to capture any additional market since it does
not have the capacity to meet the increased demand.
Therefore firm 2 would never deviate, and would set the price equal to P (k1 +k2 ).
2. There is no incentive for firm 1 to deviate: Now instead let p2 = P (k1 +k2 ),
that is firm 2 sticks to its strategy, would firm 1 find deviation from the price of
P (k1 + k2 )? By similar argument as before, no.
3 Cournot Competition
Cournot competition is one where firms simultaneously choose their optimal quantity
produced instead of prices. The manner in which we derive a solution is through
examining what the best strategy each has given their believes in what their
competition would do.
1. There are two firms (though the problem can be generalized to the mulitple firm
case), i ∈ 1, 2.
If we were to plot the choices of each firm given the other’s choices, we would get a
reaction function, as in the Bertrand case. Whereas in the latter, the reaction function
is upward sloping, the case for Cournot competition is downward sloping since as noted
before, the greater the choice of the competition, the smaller the residual demand.
ECON 312: Oligopolisitic Competition 7
p1 6
@
@
@
@
@
@
A@ @
A@ @
A @ @
P (q1∗ (q2 ))
A @ @
A @ @
A @ @
A @ @
A @ @
A @
c
@
A @ @
A @ @
A @ @
A @ @ -
q1∗ (q2 ) q1
πi = P qi − cqi
a − 2bqi − bqj − c = 0
a − bqj − c
⇒ Ri (qj ) = qi =
2b
where i ∈ 1, 2. In equilibrium, since all firms are symmetric, qi = qj , which means
that
a − c qj
⇒ Ri (qj ) = qi = −
2b 2
ECON 312: Oligopolisitic Competition 8
q1 6
AA
A
A
A
A
A
HH A
H A
q1N HHA
AHH
A HH
A HH
A H
HH
A H -
q2N q2
a − c qi∗
⇒ qi∗ = −
2b 2
a − c
⇒ qi∗ =
3b
And the equilibrium price is,
2(a − c)
P∗ = a −
3
a + 2c
⇒ P∗ =
3
which is greater than the marginal cost of c. Note further that this duopoly’s output is
greater than the monopoly’s but less than it would have been under perfect competition.
Consequently, duopoly’s prices are greater than perfect competition, but less than
monopoly’s. Can you show this is true? Read page 112 of your text. How
does the equilibrium quantity and prices change as the number of firms
increase. What if the marginal cost of the firms are not the same, that is
c1 6= c2
ECON 312: Oligopolisitic Competition 9
Of course firms may choose the choice variables sequentially, in which case the
models may be merged. For example, it is possible that capacity and pricing decisions
are separate, while the latter presents a more binding constraint, then in modelling such
a situation, we should have a two stage game, where firms first choose to make the
long run decision, i.e. capacity, before the short run decision on prices. Of course when
solving, you use backward induction, that is you find the choice of the firm pertaining
to the pricing decision given the capacity choice, substitute this choice function in the
first stage, and find the capacity equilibrium. The second stage equilibrium would then
also be resolved.
Read section 7.5 of your text. Your examinations will have similar con-
tent.